Predicting The Housing Market Is Easier Than You Think

A framework for predicting future housing price moves

Wouldn’t it be great if you could predict future house prices? If possible then you’re a step ahead of the market; while everyone else is in a state of euphoria piling their money into real estate, you’ll be able to sell your assets before the inevitable market crash.

The housing market doesn’t collapse overnight, crashes materialize over months rather than hours. Property is extremely illiquid when compared to stocks — there are limited buyers and sellers for each unit — hence creating enough time to recognize when things are starting to go right and wrong.

This framework will allow you to identify and take positions in the market; benefiting from housing euphorias, booms and busts, months before the mainstream start reacting. You’ll effectively become a housing market insider, using solid housing fundamentals and leading indicators to predict the future market.

Once you have a solid foundation in place, you will have the confidence to start investing — or taking advantage of doom and gloom — in the housing and real estate markets even without owning anything physical, but more on that later…

Step 1: Identify powerful leading indicators

Identifying the housing markets’ leading indicators is the key to predicting future price movements. The big three; building permits, housing starts, and new homes sales are the most reliable for predicting housing market health in the U.S. Released once every month respectively, the data associated with the indicators can be freely downloaded from the internet.

At the start of each month, building permits predict the number of new housing starts; new housing starts predict the amount of new homes sales and the cycle starts over. It’s a feedback loop that is missed by many traders in the financial markets. Combining all the indicators on one chart, we get a great indication of what drives house prices up and down.

If you’re not located in the United States, you can find indicators for your home country with a simple Google search.

As you can see from the chart above, the three indicators allow you to predict future house price movements. The red line shows the U.S. house price index lagging all three indicators. Once housing related indicators start to trend one way over an extended period, house prices stall and then reverse in the opposite direction.

The Subprime Crisis of 07' started to occur when house prices peaked; at this time consumer’s main income was house price appreciation. If you knew these indicators existed, you could’ve sold your real estate investments at their highs long before the crisis occurred.

The cycle is identifiable over history: The leading indicators peak, starting to report contraction as house prices begin to increase at a slower pace. They eventually decrease as supply overcomes demand and real estate valuations plummet. Once the global economy starts to recover, so does demand for housing, confirmed — once again — by rising building permits.

Step 2: Use the stock market as an indicator

In the U.S., the S&P500 index is the main barometer of the economic health, composed of the top 500 U.S. blue-chip companies — some housing related. Investors use global stock markets to express their view on the real estate and housing sectors. For example, if investors think the U.S.’s housing bubble is about to burst they will start to sell or short stocks related to the American real estate and housing market.

The S&P500 index versus US housing indicators

As the chart above demonstrates the S&P500 trended downwards during the Tech Boom and Oil Crash of 2015 while building permits continued to trend higher. Therefore, it’s a powerful indication of a potential housing bust or boom when the S&P500 starts trending along with the building permits indicator — look closely at August 2007.

If the housing market performs poorly, that doesn’t mean the S&P500 moves in tandem with our indicators, in fact, housing stocks also tend not to follow the index either; they follow our leading indicators instead.

Homebuilding stocks follow building permits, housing starts, and new home sales

Diving deeper into the market we can find stocks that follow and lag our leading indicators.

Stocks that make up the ETF follow our housing indicators with an almost one-to-one correlation; prices begin to rise and fall when there is a demand/supply shock in the market.

Homebuilders started to struggle and contract in 2007, long before the S&P500 tumbled. The doom and gloomers — who turned out to be right — began taking positions in credit default swaps on mortgage bonds just before the subprime crisis occurred, using stocks as an indication of decreasing sentiment within real estate and housing sectors.

What we’ve learned is the stock market can predict a housing crisis long before the crash occurs! It’s also important to remember that real estate and housing stocks follow the leading indicators we’ve utilized and not the stock market as a whole because the former is the most accurate barometer of housing sector health!

Step 3: Assessing the market’s liquidity

US Government Bond Yield Spread — also known as the Yield Curve

Interest rates and credit spreads play a considerable role in the availability of credit to build houses. Most consumers and businesses don’t just buy a plot of land upfront with capital; mainly because the average joe doesn’t have $500,000 in cash to blow on real estate. They finance the cost using credit borrowed from the banks and other financial institutions like Fannie Mae and Freddie Mac.

These institutions make a profit by borrowing short-term paper usually in the form of government bonds (U.S. Treasuries) while lending it out to customers over the long-term at a higher rate. The difference between the short and long-term interest rate — net interest margin — allows the banks to make their money. If the difference in the interest rate of short and long money becomes flat — or even worse negative — then it is almost impossible for banks to stay profitable.

Net interest margin matters to the housing sector because if banks can’t lend to clients and other banks in the interbank money markets, the availability of credit reduces rapidly — the supply of loans therefore affects how many houses can be constructed.

House prices are starting to correlate inversely against the Yield Curve

An inverted yield curve is not necessarily a panacea for a market crash, but it should make you aware of the potential problems that lie ahead in the future for the housing market.

Ever since the Dot-com bust in 00', house prices move inversely to the yield curve, indicating that the housing market will be the next bubble to burst eventually. We can come to this conclusion as the only thing keeping house prices propped is the availability of credit within the system — this will be tested when the Yield Curve inverts.

House prices are 30% higher than when the last housing bubble burst in 2007, indicating that even more credit has been pumped into the system than ever before; when the next crash occurs the effects could cause a severe decline in house prices.

Step 4: Analyse housing-related commodity prices

An indicator lagging all others is the commodity price of lumber. When the price of lumber crashes — like in July 2018 — it usual coincides with a peak in house prices. This makes sense: if there’s a decrease in construction demand, prices have to fall to counteract the excess supply.

There may be temporary noise in the media, but the only real factor that affects the price of lumber is supply and demand. If there is no demand for wood products, it’s a clear indication that there is a severe demand shock ahead for the market. You can be confident the smart money is watching.

Lumber prices have crashed, declining over 50% since July 2018

As the chart above shows, lumber prices precede housing stock prices. A significant crash in the lumber price is followed by stagnant house price growth. Wood products are created at the manufacturing stage in the supply chain and therefore takes time for the lack of demand to reach the manufacturer. You’ll witness this effect in every industry — if you research technology retailers vs. semiconductors, this is a prime example.

When the lumber price crash occurs it is the nail in the coffin for the housing market — something is significantly wrong.

Step 5: Predicting the future housing market

When analyzing the information gathered over the preceding steps we can come to the following conclusion: looking at the fundamentals, it’s pretty apparent there’s pain ahead for the housing market. Prices are starting to peak, and we are witnessing a slowdown in growth similar to December 05'.

Yield Curve: Approaching Inversion: Negative Outlook.Homebuilder Stocks: Down 29.78% since Jan 2018: Negative Outlook.REITs: Down ~20% or more since Jan 2018: Negative Outlook.Lumber Prices: Crash of over 40% in July 2018: Negative Outlook.

It’s too early to know for sure whether the decline will become a long-term trend but if we observe the current state of homebuilders, real estate, lumber prices, and the Yield Curve, the “smart money” has already priced in a crash. It looks like the stagnant U.S. economy is having an effect on the housing market and we may be entering a period of deflation in house prices.

Step 6: Speculate without owning physical assets

If you are looking to invest or speculate on sentiment within the housing sector, REITs (real estate investment trusts) allow you invest without owning anything physical; they are traded on stock exchanges around the world.

If you don’t have time to endure the stresses of taking out a mortgage, renovating a property and paying for upkeep and maintenance costs, then you can consider using REITs to express your view.

Real estate investment trusts are required by law to pay back 90% of their profits to shareholders. Therefore, REITs have some of the highest dividend payouts in the stock market ranging for 3–12%. If house prices don’t appreciate you still receive the annual dividend interest!

The REIT market is global: if you live in the U.S. but would like to invest in Singaporean real estate, you can simply log in to your brokerage account and buy or sell the stock in Singapore. Due to being traded on stock exchanges, you can also short them if you feel like the market is going to crash — this also applies to homebuilders and other housing-related stocks.

Last Word

Patience is critical in investing. Therefore, you might have wait for over a year to see how the market pans out before you consider profiting solely from house price appreciation. If you’re feeling brave you can also speculate by shorting housing-related stocks if building permits, housing starts, and new home sales continue to decline over the coming months.

I wish you the best of luck when entering the property market and hope the upcoming market crash doesn’t hurt you too badly. Looking at the analysis, anyone who says it’s not going to happen, is in for a big surprise.

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